Continued fee compression, the need for institutional-quality systems and processes, and a desire to reduce the regulatory and compliance burden are just some of the drivers that are pushing hedge fund managers to embrace outsourcing.
"Data management has become a critical task for us. When you take everything into consideration, it's about giving clients access to data coupled with a wide set of tools to help manage that data. It really is important to managers, especially as they increasingly move towards an outsourced model," says Christine Waldron, global head of the Alternative Investment Solutions team at U.S. Bancorp Fund Services.
In her view, outsourcing is a natural evolution of the hedge fund operating model.
"In my mind it is definitely a logical evolution of the alternative funds space to migrate to that model, especially now that regulations such as Form PF have become more formulated. Managers have done a number of filings and feel pretty confident about what they need to be. This is helping them to become more comfortable with the idea of having an outsourced provider help them manage the process," notes Waldron.
Service providers (prime brokers, fund administrators, risk specialists, etc) are necessarily adapting their product offering to bring a wider level of support to their hedge fund clients. This is happening at a time when alternative fund managers are migrating into the traditional fund market, launching `liquid alternatives' to run alongside their offshore fund(s). But as managers are finding out all too quickly, the compliance demands of running a '40 Act alternative mutual fund are completely different to running a hedge fund.
The rise of ‘RegTech’
To help its clients keep on top of risk management (including regulatory risk) and compliance, Imagine Software – one of the industry's leading real-time portfolio, risk management and regulatory systems providers – has introduced a new system called Real Time Risk and Compliance (`RRC').
"Imagine was built to provide real-time data and analytics from day one," says Scott Sherman, Co-Founder and Global Head of Business Development & Sales. "It is the foundation on which we have created the industry's most important financial solutions. In the years following 2008, as regulatory compliance became one of our clients' most important challenges, creating a solution to help them address this need became our most important focus.
"Societe General Prime Services was our first RRC client, and we have enabled them to post millions of trades per day across thousands of accounts in real time and manage their global limits monitoring."
Using RRC, Imagine's client can simultaneously manage compliance and position limits and run stress tests and scenarios to understand the impact of market shocks and determine whether a trade or series of trades would result in compliance breaches. "RRC allows firms to remain compliant in shifting markets and look ahead to stress test, for example, the outcome of the US election," says Sherman.
For the last two years, Imagine has been running the Imagine Financial Platform (IFP), which is unique in the industry in that it allows users access to all of the analytics and data in Imagine's system. Using a simple Java script, users can build their own applications to create bespoke financial calculations. More than 20 factors can be stressed within IFP to model in excess of 250 stress tests. When Brexit happened on 23rd June, Imagine enabled its clients to model the impact across all of their portfolios.
Once they model it, clients can go one step further with the RRC platform and determine what impact that would have on compliance. Imagine is able to take those stress tests and tie them in to portfolio limits or restrictions that a client might have on a liquid alternative or a segregated managed account.
"Risk managers are contending with a significant number of evolving risk considerations that are touching every part of the business. As a longstanding `RegTech" provider, Imagine can provide the strategic solutions that industry participants need to keep growing," adds Sherman.
From a fund administrator perspective, Waldron believes that data management has become a `critical task' with respect to being an effective outsourced partner. "When you boil everything down, it's about giving clients access to data and a wide set of tools with which to manage that data," says Waldron.
Outsourced regulatory reporting
This is understandable given the huge volumes of clean, consistent data that managers need to work with to meet a range of different regulatory reporting and investor reporting demands. Rather than continue to build out complex IT infrastructure using multiple systems, fund managers of all sizes are turning to outsourcing to streamline their operations, and, crucially, reduce operational risk within the work environment.
"We are definitely seeing a larger trend towards outsourcing," says Ethan Wishnick, Director Business Development, Axioma, who earlier this year acquired the regulatory-reporting and risk-reporting units of ConceptONE, a global provider of back-office investment services. "Fund managers realise that there are operational risks to their business if they are not handling their reporting requirements using a repeatable, transparent process that is consistent across a multitude of reports."
The Axioma regulatory reporting solution covers Form PF, CPO-PQR, Annex IV, Open Protocol, etc, and as well as providing the straight-through processing technology to simplify the reporting process, fund managers can leverage Axioma's team of specialists to ensure filings are complete.
Whilst investors want their managers focusing on the investment process, at the same time they are also concerned with the fact that managers are reducing risks in their operations.
"They've expanded their view of risk beyond market risk. Regulation opens up a whole other door of operational risk that they want to see being addressed; and by far the easiest way for managers to do this is to outsource it to someone who focuses on it full time.
"We provide everything from just a straight technology solution (managers wanting to retain the process in-house) to a fully outsourced managed service solution; I'd estimate 80% of our clients use our managed service solution. We are there every step of the way for these clients. It's up to the client how much they want us to be involved in the process," explains Wishnick.
Wishnick confirms that Axioma are seeing demand across the board: "A lot of the larger managers are reviewing their internal operations and realising that maybe what they have in place is not sufficient to handle the multitude of reporting."
The outsourced CCO
One of the most popular outsourced functions is the Chief Compliance Officer (CCO). Financial regulators are getting wise to this and are now starting to pay much closer attention. As far back as December 2012, the FCA issued its `Dear CEO' letter, in which it raised its concerns that many asset managers do not have in place adequate recovery and resolution plans in relation to the functions which they outsource to suppliers.
Fast forward to 2016, and the SEC has stipulated that within Form ADV, registered investment fund advisors will, as of October 2017, provide more details on separately managed accounts, aggregate data on the use of borrowings and derivatives, and disclose more information on other aspects of their advisory business. More importantly, it has updated Form ADV to get managers to provide more details on outsourced CCOs.
"We are seeing an increase in outsourcing, especially for emerging managers. With respect to running a smaller fund, does the fund manager want to be responsible and spend the time for all the compliance? Probably not. If they can't afford a full time, in-house CCO they choose to go the outsourcing route. That's one reason the SEC wants more information in Form ADV on who is performing the CCO role," explains Jeffrey I. Rosenthal, CPA, Partner- in-Charge of Anchin Block Anchin's Financial Services Group.
Rosenthal says that when the SEC does examinations and they find deficiencies in compliance, they will likely want to see "whether it is more (or less) prevalent with managers using an in-house CCO or an outsourced CCO. Or perhaps they will look to see how many investment advisors an individual outsourced CCO is working for; are they overextending themselves?
"If the SEC does find that there are issues with outsourced CCOs, they might start to impose regulation. We'll have to wait and see."
Ultimately, when it comes to outsourcing, fund managers have to strike the right balance between the risks and the rewards. It may make their lives easier, and reduce their overall operating costs, but managers should always be mindful that the more they outsource, the more risk controls they need to have in place to ensure that their appointed outsourced provider is doing exactly what they should be doing.
"Managers tend to be outsourcing more of their compliance activities and this introduces a number of risks that managers have to control," comments Barry Eisenberg, Principal, Global Compliance & Regulatory Solutions at EisnerAmper LLP. "At the end of the day, no matter how much a manager outsources, the responsibility (and risk) ultimately lies with them. Even if you've got an outsourced CCO, or your fund administrator is doing certain compliance activities, risk still lies with the advisor."
Outsourcing requires risk controls
As a result, managers need to manage and control those risks and do a cost benefit analysis of outsourcing functions and managing those associated risks, versus what they can keep in-house.
"Anti-money laundering, for example, is becoming a relevant regulatory issue for managers and most will outsource the AML function to a service provider such as a fund administrator. The proposed rules from FinCEN, however, require that policies and procedures exist with the asset manager, despite the fact that their fund administrator might be conducting the AML activities. Sufficient governance and controls must exist with the manager as they are ultimately accountable," explains Eisenberg.
There is a risk that some managers might take outsourcing a bit too far, which is no doubt why the SEC is taking a more proactive stance as it relates to Form ADV. If it makes economic sense for managers, Eisenberg says that as long as they can manage the risks and outsource in a controlled fashion, they should consider it.
"Compliance should be thought of less as a burden and more as an investment in strengthening the firm. By helping a firm reduce their regulatory and operational risk, it can result in reducing costs over the long term from any unexpected regulatory actions, and also by helping the firm create a well-run, well-controlled business that makes them more appealing to investors," opines Eisenberg.
Outsourced trading desks
Outsourcing touching our personal lives in many different ways. Why wait in a long queue at JFK airport when you can book an Uber? Why let your home gather dust if you go on vacation for three weeks when you can advertise it on Airbnb and generate cash flow?
In the automotive and aviation industries, for example, the notion of outsourcing has been in place for decades. When Airbus builds the A320 family of aircraft they outsource across the supply chain; they use Pratt & Whitney engines. They don't try and build them.
Surprisingly, the outsourcing model has taken a while to be widely adopted within the alternative funds industry but momentum is building. For smaller and emerging managers, outsourcing the trading infrastructure and having a full compliment of services, with professional traders working on their behalf, is an attractive proposition. It means they can not only reduce headcount but the number of Bloomberg terminals, the amount of office space, and so on.
One firm that is seeing a lot of demand for its outsourced trading desk is Cowen Prime Services.
"It is becoming a more acceptable alternative among asset allocators, as well as managers," says Jack Seibald, Global Co-Head of Prime Brokerage, Cowen Prime Services. "We offer the full complement of all of our services regardless of whether the client engages us for full PB or outsourced. The only difference is that they have their account primed at one of the bulge bracket firms as opposed to being introduced by us to one of our clearing firms."
Importantly, the executing broker knows the client's portfolio and receives the order in the name of the client and settles the transaction directly into the fund's account. From the executing broker's perspective, this is a better model as they know the client at the time the order is received and transacted.
"The client further benefits by having our team support them when there are trade breaks as a result of incorrect pricing, quantity, or commissions reported by the executing broker," confirms Seibald. "We deal with all of that first thing in the morning and make those corrections on behalf of the client. We also do portfolio reporting, separate and distinct from what they are getting from their fund administrator or prime broker. It's an extra set of eyes that we provide – a shadow set of books and records, so to speak – for the client to compare against the official books and records.
"All of this is consistent with our PB offering, but very different from other outsourced trading solutions provided on the Street."
Cowen is also able to offer outsourced trading in London to European hedge fund managers. Kevin LoPrimo joined in June as Managing Director, Head of International Prime Brokerage. It already has two traders in place who previously worked at Brevan Howard and Tudor Investment Corporation. It's unlikely that many start-up managers would have access to that kind of talent and once again underscore the benefit of outsourcing.
Seibald says that the client pipeline improved noticeably in early spring. "We have been onboarding a lot of those new clients in the past few months and have several more large ones scheduled for the next couple of months."
Picking the right outsourced partner is vital. Eisenberg suggests that managers should do a detailed review of the outsourced provider's governance structure, including policies, procedures and controls, "and ensure that the contract between both parties allows for scrutiny of their operations on a regular basis. The manager needs to do their homework to ensure that they are selecting the right provider, at all times, and that they are not exposing themselves to any undue risk."
The turnkey solution
One final outsourcing option is for managers to avail of a turnkey solution to get a fund to market. Simply put, this involves interacting with one point of contact that helps with every aspect of setting up a fund and making sure it remains in compliance.
Whereas a few years ago, managers were jumping in to the '40 Act mutual fund market to either launch standalone alternative mutual funds or become sub-advisors to multi-manager products operated by the likes of Fidelity, the fact is that there are so many restrictions on these funds that trying to replicate a hedge fund strategy – or even a diluted version of it – is difficult.
With performance lagging (the average alternative mutual fund returned -2.77% in 2015 according to Preqin), a more effective alternative is the registered private fund; also known as an interval fund. Over at UMB Fund Services, its Registered Fund Services platform gives managers the opportunity to launch one of these products that are able to take daily subscriptions but only have to redeem once a quarter (and even then this is limited to between 5% and 25% of the fund's assets).
"As managers expand their product offering they are increasingly considering the interval fund structure. New managers are often those who have spun out of existing companies and are already familiar with how private fund structures work, they know where the asset opportunities are, and they decide to start their business with one of these funds," says Tony Fischer, President of UMB Fund Services.
He concludes by saying that there has been so much regulatory change that it's incredibly difficult for managers to keep on top of everything: "Part of what we do as an administrator is provide both the insight and oversight to make sure we support our clients' regulatory obligations."
